Commodity Trade Mantra

Forget HFT: The 4 Greatest Market Risks To Investors Now

Forget HFT: The 4 Greatest Market Risks To Investors Now

Forget HFT: The 4 Greatest Market Risks To Investors Now

The financial media discussions regarding high-frequency trading have reached a fevered pitch. No pun intended as the igniter of this public relations flame is famous author of “Money Ball” Michael Lewis who has been making the television circuit promoting his new book “Flash Boys.”

Heated public discourse about how the stock market is “rigged” by the high-frequency traders has caught the attention of the Justice Department. So, you’re telling me this is a new condition? Please.

Let’s provide some perspective to the argument.

First, the market is not your friend. It’s not the focal point for the pervasive inequality rhetoric circulating through politics and the media today.  It’s regulated to the point of sublime, so that’s not it, either. “Greed” and “fear” are the oils that run the machine. Some possess more oil than others. That’s how it works.

Get over it.

Since you’re going about your daily business working a job, trying to provide for your family, making it to the kids’ soccer games, let us expand on the impact of HFT on you.  High-frequency traders utilize powerful technological tools to rapid-fire trade securities. Sophisticated computer models seek to exploit penny differences in prices of stock long before you as a retail investor even hit the enter key to electronically purchase 100 shares of Coca Cola.

While many “experts” claim that HFT provides greater liquidity and transparency, the markets seemed to operate efficiently enough for the last 100+ years.  However, while technological advancements can be beneficial, they open the door to the many nefarious individuals which will choose to exploit it to their advantage by employing the following:

  • Frontrunning: needs no explanation
  • Subpennying: providing a “better” bid or offer in a fraction of a penny to force the underlying order to move up or down.
  • Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
  • Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
  • Order Book Fade: lightning-fast reactions to news and order book pressure lead to disappearing liquidity
  • Momentum ignition: an HFT trader detects a large order targeting a percentage of volume, and front-runs it.

This is clear manipulation of the prices to anyone who has a vague understanding of how financial markets operate. However, here some of the more insightful writings to help you gain clearer perspective on what HFT is, and isn’t.

How to Unrig the Stock Market.

HFT is no BFD for Buy/Holders.

HFT all you need to know

With this in mind here are some thoughts to consider.

1). Markets have and always will be “rigged” to some degree.

C’mon we’re not that stupid – this shouldn’t be big news. We have the finest stock markets in the world, but guess what – there will always be someone faster than you, smarter than you and willing to spend the money and time to create algorithms to try to gain an edge. In the 1930’s, it was a consortium of banks and wealthy families. Today it’s programmed traders who move like serpents in the underbelly of markets and nip at your wallet. Even Ray Dalio has stated that if you want to play in the markets you had better come to the table ready to beat him, his hundreds of financial professionals and billions of dollars in technology. If you don’t that – you should.

However, this doesn’t mean you can’t be a long-term participant and take advantage of momentum. How can you attach to the stars of these HFT players and take advantage of what they do? Investors in the market since the bottom of March 2009, have benefitted by returns close to 200% (talk about a home run).  Change your perspective. Turn around your mindset. As Michael Corleone lamented in “The Godfather “keep your friends close but your enemies closer.”  You can make money in “rigged markets” but you can’t lose sight of reality.

It’s a double-edged sword, obviously. While you can make money by riding the wave up, you can lose more when the trend changes.  Despite what the daily blathering of Wall Street analysts and financial professionals needing your money to create their profits, rising markets will end, and end badly.  They always have, they always will.  It is the cycle of life.  To profit alongside HFTraders, you can no longer be a “buy and hold” investor. If you work with a financial professional who believes your investments are set and forget, you need to move your legs, and accounts, out of there.

Ask your advisor today: What’s your sell discipline? You will like see them almost pass out in front of you.

2). Let’s reveal the TRUE market manipulator: The Federal Reserve.

The biggest driver of asset prices over the last 5 years has been the direct monetary interventions of the Federal Reserve.  Over the last couple of years, we have updated our analysis of the correlation between the Federal Reserve’s monetary interventions and the S&P 500 (latest update here).  I have also projected the theoretical conclusion of the Fed’s program by assuming a continued reduction in purchases of $10 billion at each of the future FOMC meetings.

If the current pace of reductions continues it is reasonable to assume that the Fed will terminate the current QE program by the October meeting.  If we assume the current correlation remains intact, it projects an advance of the S&P 500 to roughly 2000 by the end of the year.  This would imply an 8% advance for the market for the entirety of 2014.

Such an advance would correspond with an economy that is modestly expanding at a time where the Federal Reserve has begun tightening monetary policy. (Yes, Virginia, “tapering” is “tightening.)

Historically speaking, such retractions of support from the financial markets have not fared well for investors as the ongoing “carry trade” is unwound.  The problem for most individuals will be understanding the difference between a “dip” and a full blown reversion, until it’s too late.

3). Investors rig themselves mentally for anemic returns. Investors are saddled with behavioral and cognitive biases.

  • We sell our gainers too quickly
  • Hold on to losers
  • We trade too much
  • We trade too little
  • We chase performance
  • We don’t understand our behavioral makeup
  • We buy high
  • We sell low
  • We suffer from confirmation bias (we only research that which confirms our opinions)

While the markets have rallied nearly 170% from the 2009 lows, most individuals did not garner those returns.  They were buying into the peak of 2008 because Wall Street told them that it was a “Goldilocks Economy”, they held on during the entire crash because Wall Street told them too, and they finally sold at the bottom when the losses were too great to bear.  Unfortunately, it took nearly four years from them to come back to the market, most likely very near the next major market peak. Wash, rinse, repeat.

4). Your broker may be rigging you. It’s ironic how financial services CEOs can exploit HFT for their own benefit to gain publicity and rail against it when they advocate their front-line sales forces to engage in HPST (high-pressure sales tactics) which are exponentially more detrimental to the wealth of retail investors.  I don’t recall these CEO’s suggesting “don’t invest until HFT is fixed,” do you?

Of course not.

They tell you to “buy and hold”, purchase your full asset allocation to stocks regardless of valuations and they never share what could happen if you miss the 10 WORST market days, only if you miss the 10 BEST.

(By the way, if you miss the 10 WORST trading days in the markets you will generate substantially greater returns than missing the 10 BEST.  You won’t get that information, however, because it means less invested in stocks, less trading and fee revenues for the brokerage firms.)

So let’s get real, here.

While HFT is a headline, a media grabber, it really has very little effect to your bottom line.  However, what has the most important effect on your long term financial prosperity is managing the risks of investing that can do long-term, irreparable damage to your financial health.

As discussed recently, it makes little sense to focus only on what could go right. You can readily find that case being made in the mainstream media daily. However, finding an advisor that can understand the impact to portfolios when something goes “wrong” is inherently more important.

However, an independent advisor can help level the playing field between Wall Street and you.  Provided they have the right team, tools and data they can spend the time necessary to manage portfolios, monitor trends, adjust allocations and protect capital through risk management.

If the market rises, terrific. It is when markets decline that we truly understand the “risk” that we take. A missed opportunity is easily replaced.  However, a willful disregard of “risk” will inherently lead to the destruction of the two most precious and finite assets that all investors possess – capital and time.

I don’t know about you – but I’m not getting any younger.

 

 

Courtesy: Lance Roberts

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The views and opinions expressed herein are the author’s own, and do not necessarily reflect those of Commoditytrademantra.com or Moneyline.co.in.

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